As is often the case, United CEO Scott Kirby gave a masterclass on where he sees the airline industry going during his initial comments in the airline’s earnings call last week. There was a lot of talk of comparing revenue to Gross Domestic Product (GDP) and how cost convergence would result in higher profits. This may be tough to follow, so I thought I’d break it down to explain exactly what Scott is seeing.
Revenues as a Higher Percent of GDP
Over the years, comparing airline revenues to GDP or comparing growth in airline revenues vs growth in GDP have been commonly-used metrics. Depending upon the timeframe used, it can be a good but very general judge of if the airline industry is growing too fast or not fast enough to keep up with economic growth. That is where Scott’s story begins, but I should make it clear that his comments were zeroing in specifically on the US industry here and he’s looking at domestic revenues only.
Taking domestic airline revenues and comparing them to the US GDP, we get this slide which United included in its presentation:
Before 9/11, there was a completely different dynamic with GDP. Fares tended to be much higher, leading to higher revenues, and low-fare carriers were a smaller piece of the industry. But there was a permanent shift starting after 9/11 when fares tumbled due to the dramatic drop in demand. Low-fare airlines started to grow significantly and the legacy airlines spent the next decade trying to find the right way to deal with the demand environment, creating low-fare carriers of their own. (Remember Ted, Song, Metrojet… you name it? Now forget them. Those were all terrible ideas.)
This lowering of revenue decoupled the airlines from their GDP reference point. Even as airlines were adding capacity, the fares were not keeping up. In the decade before the pandemic, it settled into a steady place where domestic airline revenues were 0.49 percent of GDP which, as legend has it, is how the San Francisco 49ers got their name.
During the pandemic, all hell broke loose. There’s no reason to even bother thinking about what happened during those dark times, but it should be noted that the estimate for 2022 is that it will climb back to 0.45 percent. If you remember, fares were still pretty low at the beginning of 2022 when Omicron reared its ugly head. They rapidly picked up steam in the second and third quarter, however.
Consider this: according to DOT data, domestic airline revenue in Q1 was $41.2 billion in Q1. It soared to $55.3 billion in Q2 and $53.1 billion in Q3. If we hit 0.45 percent in 2022, then getting back to the now-standard 0.49 percent in 2023 should be possible. And Scott made it clear in his remarks that he sees opportunity to get back up to the mid 50s. Blue skies ahead for everyone (except the 49ers).
The Magic of Cost Convergence
In a sense, this is all backwards looking. The question is… why would the industry be able to get above where it’s been for the last decade? And that’s where this gets much more interesting.
Ultimately, this comes down to what Scott calls “cost convergence.” As he sees it, the low-fare carriers will have their costs get closer to the costs of the legacy airlines. Just doing the math, that will force fares up and that’s good for the legacies. Here’s a crude map with no real numbers just to illustrate the point.
The idea is that the low-fare carriers are the price leaders and the legacies must compete with them. If the ULCCs have higher costs, their fares will have to rise to maintain their current level of profitability. This will allow legacy fares to rise as well (not as fast since not all fares match ULCCs), but since legacy costs are going up more slowly, legacy profits will increase.
Poof… MAGIC. But WHY are ULCC costs increasing faster? Scott had several reasons for that.
Pilots, Pilots, Pilots, and Other Stuff
The biggest impact on costs will be the ongoing pilot shortage. The legacy airlines are setting the bar. We have a very rich contract on the table for Delta. If that gets approved, I think we can all safely assume that American and United will follow with something similar if not identical. So, pilots will get trained up and once they reach the 1,500 hours required to fly for an airline, they’ll roll into the regionals as a de facto training program. The regional flow-through programs are a way to get put right into the high-paying legacies after a short time.
Regionals had to jack up their pay dramatically, but now that combined with the promise of drastically increasing legacy pay within a couple years will keep the pipeline flowing and the legacies as the preferred pilot destination. If the supply remains tight, how do the other airlines get pilots if they aren’t paying as much and the pilot pool remains shallow? The ULCCs seem to believe that with legacy pay jumping so much higher, they’ll have plenty of room to increase and still attract people. Whether that’s true or not, only time will tell.
They will always be able to get some pilots. After all, some people like the bases that one airline may offer over another. Another person may like flying for, say, Allegiant, because they get to sleep in their beds every night. But for these airlines to grow, they need to attract a lot more than just those niche groups. Spirit pilots just approved a new agreement, and that will certainly help. But the way Scott views it, that won’t be enough. If they can’t get closer to legacy pay, they are never going to be able to staff all the growth that’s on the order books. At least, that’s the narrative being put forth, but it’s not a guarantee.
At some point, the pilot shortage has to ease compared to what we have now. The demand for pilots is through the roof, and the economy is booming. Growth will slow, the economy will turn down, and more pilots will probably come into the system. Some things, like the 1,500 hour, aren’t likely to change, so that will keep the squeeze on the pilot pipeline. Ultimately, however, there is going to some a cyclical nature to this and we are at the top of the cycle.
The key here, however, is that Scott isn’t saying the ULCCs won’t get any pilots. He’s saying that for them to be able to get enough pilots to fund all their planned growth, they’ll have to pay relatively closer to what the legacies pay than has been the case historically. That’s cost convergence.
But pilot pay is only part of it. Scott also says that more employees are needed to run every flight because sick calls are higher. At United, the back half of 2022 saw sick calls 19 percent higher than the back half of 2019. United views this as a permanent shift and not one that will go back to where it was. The other airlines will either have to be fine running a worse operation or they’ll have to hire more and increase costs. Even if they want to hire more, it may be tough to do without increasing pay again. Since the ULCCs have already run leaner operations, it might require them increase more than the legacies… cost convergence.
On top of this, there are two things that will keep a lid on capacity. First, the aircraft manufacturers are behind and can’t catch up. So, deliveries are delayed and all those airlines that retired a bunch of aircraft during the pandemic are now just waiting for more capacity. I expect this will eventually ease, but it does keep a lid on things in the near to medium term at least.
Also, and what is presumably a bigger, long-term issue is the country’s air traffic control system. As Scott sees it, we’ve basically hit our limit on capacity in the US, at least in certain parts of it. Sure, there can be more on clear days and you can fly to and from any city in Eastern Montana as much as you’d like, but additional growth where the bulk of the population lives is just going to compound these meltdowns that have become more and more regular. This used to be primarily an issue in the northeast, but we’ve also seen several air traffic slowdowns in Florida as of late. Unless the government does something about that, growth will have no choice but to slow down.
When you combine that all together, what do you get? You have lower capacity than airlines would like along with higher costs. That will push fares higher, and with cost convergence, that will lead to higher legacy airline profits.
Will This Happen?
We do have to keep in mind that this comes from the CEO of a legacy airline. This kind of pressure on his non-legacy competition is music to his and his shareholders’ ears, and it tells a grand story that supports United’s future. That being, said, Scott has a strong track record when it comes to predicting macro changes.
There are still a lot of “ifs” here that are out of anyone’s direct control. Pilot demand will shift, but will ULCCs be able to maintain pay at the levels they are at right now? I’d imagine some will do better than others, but it’s not entirely clear how this will play out. Will sick rates stay where they are? Maybe. Maybe not. Scott is much more confident about the path than I am, but I can certainly see how it could play out this way, and I think it would be a mistake to just write off the idea completely.